Ali’s blog

Mostly quant stuff with occasional digressions

On risk

Posted by alifinmath on February 3, 2008

Here is an excerpt from an excellent post (Jan.27, 2008) in the superb Econophysics Blog:

QUOTE

People thought that the “spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis” (from David Leonhardt’s article). Quite the contrary, it is the spreading of financial risk that has led to the spreading of the crisis. Just as infectious diseases become more contagious when a virus or a bacteria takes advantage of the network effects of the interlinked relationships between their human hosts, financial contagion can now spread through more channels than in the past.

We were told that financial derivatives is another way of taming risk. Although derivatives can be validly used in risk and investment management, there are those who want to — in the infamous, quasi-fictional words of Satyajit Das’ ‘Nero Tulip’ — lever up as much as possible via ever dizzying combinations of options, swaps, futures, special purpose entities, etc. In the recent past, we were lucky on a Clouseau-esque level to not have had all this ‘hidden’ leverage blow-up on us. Our luck ran out. Risk can’t be tamed. It can’t be controlled in some simplistic, mechanistic way. That’s the mirage we believed in. We put our faith in the good fortune of Jacques Clouseau all the while missing the thieves getting way with the loot.

UNQUOTE

This resonates with me and I think some profound and non-trivial points are being made; albeit some fleshing-out of the perspective that risk is fell and untameable would have been helpful.

There are courses on risk management and portfolio theory available at every business school. Indeed, one can argue that the entire raison d’etre of MFE programs is to teach students how to play with risk, manage it, hedge it, and profit from it. My feeling is that both conceptual tools and computational power lull students, teachers, and practitioners into a false sense of confidence and complacency. My feeling is also that this “science” is built on a foundation of quicksand, and the epistemological basis for the various theories — for derivatives and for portfolios — is suspect in both an empirical and a theoretical sense. But I’m not yet at a point where I can put forward compelling and detailed arguments to lend credibility to these feelings (which are slowly hardening to convictions).

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